Where Do Returns Come From?

You don’t need a lot of mathematical horsepower to be a Couch Potato investor. Indeed, simplicity is one of the strategy’s virtues: just keep your costs low, diversify widely, and stick to the plan. But if you’re a finance geek, it can be fun to delve into the more arcane theories behind index investing.

One of the most interesting chapters in Rick Ferri’s The Power of Passive Investing (Wiley, 2010) looks at how academics have learned where investment returns come from. Twenty years ago, if a money manager beat the market, it was pretty much impossible to explain why. Was the outperformance due to skill (or alpha)? Did the manager simply take more risk? Or did he just get lucky? Until recently, we didn’t have the tools to answer those questions.

Now we can get very close. The work of professors Eugene Fama and Kenneth French in the 1990s showed that a portfolio’s returns can be largely explained by three risk factors: its overall allocation to stocks (called the market factor, or beta), its exposure to small-cap stocks (the size factor), and its exposure to stocks with high book-to-market ratios (the value factor). In plain English, this means stocks are riskier than fixed-income investments, and therefore should deliver higher long-term returns. In addition, small-cap and value stocks are riskier than the overall market, and therefore also have higher expected returns.

The power of three

All of this might seem obvious today. The idea of beta (the first of the three factors) has been around since the 1960s, and the first studies showing that small-cap stocks outperform large caps appeared in the early 1980s. Value investing is an even older idea. “People have known that value stocks outperform since the beginning of the last century,” Ferri explained in our recent interview. Benjamin Graham and David Dodd published Security Analysis in 1934, and the book is still widely read today. Less well known is John Burr Williams’ The Theory of Investment Value, published in 1938. “Williams talked about how important dividends are. From the 1880s through to the 1950s, stocks typically paid over 60% of their earnings in dividends. So the book was basically about how investment value is based on dividends, which is a value-type factor.”

The problem with these early investing theories was that they couldn’t be quantified. Before computers and databases of historical returns, it was impossible to tease out these factors and use them to explain a portfolio’s performance. There were also different ideas of what a value stock was. Did that mean one with a high dividend yield? A low price-to-earnings multiple? A high book-to-market ratio?

The analysis began in the 1970s, Ferri explains, “but it was Fama and French who really quantified everything and put it all together. They were able to create a simple, elegant model of why portfolios perform the way they do.” This elegant model demonstrated that a money manager’s supposed skill could be an illusion. A fund’s outperformance may not be due to alpha at all; it might simply be the result of the fund’s exposure to the Fama-French factors.

Think of it like this: no one celebrates an equity fund manager who outperforms a bond fund, because it doesn’t take skill to simply accept stock market risk. Fama and French took this idea two steps further. Say, for example, a Canadian equity fund beats the S&P/TSX Composite Index over some period, and the manager takes credit for her superior stock-picking skills. An analysis using the Fama-French model can reveal whether the fund had more exposure to small and value stocks compared to the overall market. If it did, then the manager did not add any alpha. Investors in the fund were simply compensated for taking more risk.

No need to pick stocks

Ferri elaborated on this idea in our chat. “What this means is that you can analyze the monthly returns of any broadly diversified stock portfolio over a 10-year period, and without knowing anything else, you can determine what percentage was in value stocks, and what percentage was in small-cap stocks. Then when you actually look at that the portfolio to see what stocks were in it, lo and behold, that’s the way it was invested. The model is rigorous, and it’s statistically significant.” Fama and French found that beta alone explained about 70% of returns, while the size and value factors accounted for another 25%.

The upshot was that now you didn’t need a brilliant manager to pick individual stocks: you could simply design a portfolio that was exposed to the Fama-French risk factors in whatever proportion suited your goals. “Now we have a new model for building portfolios, and you can use passive funds to do it. You don’t need security selection: you’re going to get 95% of the way there with index funds. And the lower cost of doing it this way overrides any benefit that you might get from individual security selection.”

So if your investment strategy is based on picking individual securities, or on hiring professional managers to do that for you, the Fama-French research suggests that these decisions will impact a mere 5% of your portfolio’s overall performance. Even then, chances are that the impact will be negative.

70 Comments

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I am actually an index investor and a fan of your web site. But I am also a stickler for detail and I just don’t agree with this inference that John Burr Williams originated value investing, or that he had some kind of profound influence on Ben Graham’s work. I also must add, that I don’t view Wikipedia as a credible source.

Ben Graham started teaching at Columbia in 1928, 10 years before John Burr Williams’ book was published, and as mentioned before, published Security Analysis in 1934, 4 years before Burr Williams book came out.

I pulled my copy of The Theory of Investment Value from my bookshelf today, and noted that Ben Graham’s name is in the index and Williams makes reference to Graham’s book Security Analysis early on in his book. So Williams certainly was familiar with Graham’s work.

I do not have a copy of the 1934 edition of Security Analysis, so I don’t know if Williams is referenced in it. BUT I do have the sixth edition of Security Analysis (based on the 1940 edition) printed in 2009. In the introduction, the well known financial author James Grant states that Graham was given a copy of Williams’ book in 1939 to review (5 years after Security Analysis was published and 11 years after starting to teach at Columbia) .

On Williams point that the value of a stock is the present value of all future dividends, Graham “voiced his doubts about that forecast.” From Graham’s review of Williams book, “One Wonders whether there may not be too great a discrepancy between the necessarily hit-or-miss character of these assumptions and the highly refined mathematical treatment to which they are subjected.” This, to me, does not sound like a person who was influenced by what Williams was trying to prove.

To say, ““The idea goes back to a book by John Burr Williams called The Theory of Investment Value, published in 1938″, and infer that this is before Graham’s work, is just not correct. To also infer that Graham somehow got his ideas from Williams is also not correct.

I don’t have the interest in this to do more specific research on this, but I know that Graham was writing articles on value investing for financial periodicals prior to 1920, more than 18 years before Williams book was published.

You will have to come up with more than a quote from Wikipedia to change my mind on this one.

@Jim: Please note that I was quoting from our conversation, and Ferri may very well have mixed up the chronology during our interview. In his book he merely calls Williams “one of the early pioneers of value investing” and makes no mention of him being an influence on Graham. I made some edits to the post to set the record straight.

My apologies if I perpetuated the error. Really, though, the detail has no bearing on the argument of the piece, which is simply that value investing is an old idea, but these early pioneers did not have the historical data nor the computing power to quantify their theories.

Toyin
March 26, 2011 at 12:36 pm

As always a very interesting piece. Since DFA funds are not accessible to DIY investors, my portfolio is closer to your Uber-Tuber portfolio.

Chuck
March 26, 2011 at 12:58 pm

Great post. I’m just starting out as an invester and have chosen the passive path. Interesting theories here about biasing toward value and small-cap. I guess I’ll have to read more into it! *wink*…

Toyin
March 26, 2011 at 1:10 pm

I read on another blog that Rick Ferri totally dismissed all form of active management and fundamental indexing. I agree the majority of investors will do better indexing. However guys like Rob Arnott should not be too quickly dismissed for his work on fundamental Indexes. He now has over $50 billion under management. I hope i win the book.

@Toyin: I asked Rick about his opinion of fundamental indexing, and he’s not against it at all. In fact, most DFA folks I’ve spoken to like the RAFI indexes. But they tend to feel they are just value indexes that use four factors (dividends, sales, book-to-market and cash flow) to weight the stocks, as opposed to DFA, which focuses only on book-to-market.

Here’s a quote from our interview: “The methodology is sound. But I argue with [Arnott] about the marketing, where he says this is some magical way of collecting alpha… If you want to do a tilt in your portfolio away from cap-weighting to smaller cap or value, then the RAFI way of doing it is perfectly acceptable. It’s just what he’s calling it that bothers me. He’s calling it alpha, and I’m saying no, let’s not go down that path.”

Winnie
March 26, 2011 at 6:07 pm

Interesting article, thank you. Timely for me. I’ve pulled my head out of the sand, and reviewed my portfolio return from my full service brokerage. Over the past 6 years & numerous trades, my financial advisor netted me a significant loss. I intend to take a more active role & articles such as this should help. Thanks again. ps: Pick me ! please.

Veronica
March 26, 2011 at 11:39 pm

Great article…
It’s always nice to see someone explaining the underlying theory, even if you may not understand it all right away.

I like to think i’m continuously learning, and this site definitely helps with that goal.

thanks for the this and the many other very helpful articles you’ve written in past on Couch Potato Investing . This one is especially reassuring , seeing that I only switched to mostly Passive index type investing in 2008.

I hope I win …..

Jason
March 27, 2011 at 4:11 pm

Thanks for the great post! Would love to win the book.

david
March 27, 2011 at 4:46 pm

great post , would be an interesting read

Debbie
March 27, 2011 at 8:50 pm

I’m really enjoying your blogs and learning a lot. We’ll be making some major changes to our investing , thanks in part to what I’ve learned on your site. (It would be great to win that book!!)

Steven
March 27, 2011 at 9:55 pm

Your site is terrific–Keep up the good work!

-The Newest Couch Potato

Maxwell C.
March 28, 2011 at 2:57 pm

Ah, damn. Due to my computer having broken down and my not wanting to read this wonderful site on my Android phone, I missed out on this potential win. Oh well, excellent article though, and I`m certain to not miss out on the potential wins of passive investing ;-)